Europe’s political leaders are deeply divided over how to manage the economic consequences of the Covid-19 outbreak. Dimitris Katsikas writes that without a sizeable common funding mechanism, the danger is that European economies will be on very different fiscal and macroeconomic trajectories once the health crisis is over. However, the correction of these imbalances would come at a high economic and political cost, and further divisions between states could ultimately put the future of the Eurozone at risk

Katsikas, Dimitris

English

LSE Research Online

A	rift	that	never	healed:	How	old	divisions	areundermining	the	Eurozone’s	futureEurope’s	political	leaders	are	deeply	divided	over	how	to	manage	the	economic	consequences	of	theCovid-19	outbreak.	Dimitris	Katsikas	writes	that	without	a	sizeable	common	funding	mechanism,	thedanger	is	that	European	economies	will	be	on	very	different	fiscal	and	macroeconomic	trajectoriesonce	the	health	crisis	is	over.	However,	the	correction	of	these	imbalances	would	come	at	a	higheconomic	and	political	cost,	and	further	divisions	between	states	could	ultimately	put	the	future	of	theEurozone	at	risk.The	coronavirus	pandemic	is	an	unprecedented	health	crisis	with	tragic	humanitarian	consequences.	At	the	sametime,	it	is	a	major	economic	trial,	particularly	for	Europe,	which	stands	at	the	heart	of	the	global	pandemic.	Therequired	fiscal	intervention	constitutes	a	challenge,	whose	scale	is	magnified	for	the	Economic	and	Monetary	Union(EMU),	which	has	experienced	a	deep	economic	crisis	in	recent	years.	The	EMU	came	out	of	the	crisis	burdenedwith	economic	problems,	political	divisions	and	no	common	fiscal	and/or	debt	instruments	to	help	her	navigatethrough	a	future	economic	shock.	Alas,	the	shock	came	earlier	than	anticipated	and	exceeds	by	far	any	adversescenario	previously	considered.Some	member	states,	mostly	in	the	south,	are	burdened	with	high	levels	of	public	debt,	which	makes	it	harder	toemploy	the	fiscal	resources	necessary	to	combat	the	pandemic	and	most	worryingly	raises	the	prospect	of	anotherdebt	crisis	the	day	after.	To	avoid	this,	the	EMU	needs	common	fiscal	and	debt	instruments,	which	however	entailrisk	mutualisation	and	a	certain	degree	of	fiscal	transfers.	For	Germany	and	its	allies	such	a	prospect	isunthinkable,	and	they	resist	it	fiercely.As	a	result,	old	divisions	over	the	handling	of	the	debt	crisis	have	reappeared;	European	leaders	try	to	find	commonground,	but	they	stand	a	long	away	apart.	The	Eurogroup’s	deal	on	9	April,	provides	temporary	relief,	but	does	notoffer	the	definitive	solution	required.	The	stakes	are	high;	if	the	Eurozone	fails	to	deal	effectively	with	a	majoreconomic	crisis	for	the	second	time	in	a	decade,	the	consequences	could	be	dramatic.Unresolved	disputes	and	incomplete	reformsAfter	the	outbreak	of	the	global	financial	crisis,	and	in	the	midst	of	the	debt	crisis	that	followed,	the	EMU	embarkedon	an	ambitious	reform	effort.	Germany	and	other	fiscally	like-minded	member	states	were	able	to	dictate	terms;their	priority	was	to	limit	‘moral	hazard’,	i.e.	the	risk	that	debtor	countries	could	use	the	loans	they	received	(or	theability	to	borrow	through	a	common	debt	instrument	–	a	Eurobond),	to	avoid	implementing	politically	costly,	buteconomically	necessary,	reforms.	This	could	potentially	result	in	permanent	fiscal	transfers	to	those	countries,leading	to	a	‘transfer	union’	at	the	expense	of	the	creditor	member	states.Accordingly,	the	main	fiscal	reforms	have	comprised	mechanisms	of	enhanced	national	fiscal	discipline	andsurveillance.	The	coordination	of	an	EMU-wide	fiscal	stance	continues	to	be	an	unrealised	objective	and	thestabilisation	function	has	remained	at	the	national	level.	Moreover,	proposals	for	the	creation	of	a	European	safeasset	did	not	progress.	In	other	words,	the	EMU,	continues	to	lack	substantial	common	fiscal	and/or	debtinstruments.Despite	the	increasingly	shared	acknowledgment	that	the	‘reformed’	fiscal	governance	remains	incomplete	and	inneed	of	further	reform,	progress	has	not	been	forthcoming.	The	main	obstacle	is	the	political	economy	struggle	thatcontinues	to	pit	fiscal	conservatives	preaching	against	the	risk	of	moral	hazard	against	supporters	of	fiscalsolidarity.	The	economic	recovery	seen	in	recent	years	has	not	changed	the	terms	of	this	struggle	as	the	Eurozonecrisis	casts	a	dense	and	long	shadow.	Its	legacy	includes	non-performing	loans,	high	levels	of	public	debt,	andoutput	and	investment	gaps.	Dealing	with	the	adverse	legacy	of	the	crisis	requires	further	adjustment,	which	comesat	substantial	economic	and	political	cost.	The	distribution	of	this	cost	is	a	highly	political	issue	and	has	divided	theunion	between	proponents	of	risk	reducing	and	risk	sharing	options.LSE European Politics and Policy (EUROPP) Blog: A rift that never healed: How old divisions are undermining the Eurozone’s future Page 1 of 5		Date originally posted: 2020-04-16Permalink: https://blogs.lse.ac.uk/europpblog/2020/04/16/a-rift-that-never-healed-how-old-divisions-are-undermining-the-eurozones-future/Blog homepage: https://blogs.lse.ac.uk/europpblog/Finding	a	way	to	overcome	this	divide	has	acquired	new	urgency	in	view	of	the	coronavirus	pandemic,	as	countriesneed	to	employ	fiscal	resources	at	an	unprecedented	scale.	Italy	and	Spain,	the	two	countries	at	the	heart	of	thepandemic	in	the	EU,	have	a	public	debt	of	136	and	97	per	cent	of	GDP	respectively.	Greece	whose	public	debtstands	at	175	per	cent	of	GDP	and	Portugal	with	a	public	debt	of	120	per	cent	of	GDP	are	also	vulnerable.	Thescale	of	the	challenge	was	quickly	perceived	by	the	markets	and	the	yields	of	these	governments’	bonds	increasedrapidly	(Figure	1).Figure	1:	European	sovereign	bond	yields	(10-year	bonds,	selected	countries)Source:	Investing.comIn	such	circumstances,	the	fiscal	space	of	these	countries	is	constrained.	It	is	interesting	to	note	that	their	initialresponses	to	the	crisis	were	very	limited	in	terms	of	direct	fiscal	transfers	–	paying	out	public	funds	–	and	reliedmore	on	tax	deferrals	–	delaying	tax	revenues	–	and	mostly	on	the	provision	of	guarantees	for	loans	to	the	privatesector,	which	do	not	necessitate	any	immediate	pay-outs	(Figure	2).	Although	all	countries,	including	Germany,employ	deferrals	and	guarantees	more	than	direct	fiscal	transfers,	the	magnitude	of	direct	fiscal	intervention	for	thecountries	under	stress	is	particularly	small;	Italy,	Spain	and	Portugal	have	committed	resources	of	less	than	1%	oftheir	GDP.	The	contrast	with	Germany’s	4.5%	is	striking.Figure	2:	Economic	responses	to	the	coronavirus	crisis	(up	to	3	April,	selected	countries)Source:	ELIAMEP	compilation	based	on	IMF,	OECD	and	Bruegel	dataLSE European Politics and Policy (EUROPP) Blog: A rift that never healed: How old divisions are undermining the Eurozone’s future Page 2 of 5		Date originally posted: 2020-04-16Permalink: https://blogs.lse.ac.uk/europpblog/2020/04/16/a-rift-that-never-healed-how-old-divisions-are-undermining-the-eurozones-future/Blog homepage: https://blogs.lse.ac.uk/europpblog/The	EMU’s	path	dependent	initial	reactionWhat	was	the	EMU’s	initial	reaction	to	this	unprecedent	situation?	It	followed	the	same	decentralised,	‘individualresponsibility’	rationale	that	dominated	both	the	handling	of	the	debt	crisis	and	the	reform	effort	that	followed;	theidea	is	to	allow	states	to	deal	with	the	crisis	as	they	see	fit,	within	the	limits	of	their	fiscal	and	macroeconomiccircumstances,	without	committing	to	substantial	common	resources	or	assuming	common	responsibilities.The	measures	announced	by	the	European	Commission	and	the	EIB	are	well	below	€100	billion,	less	than	0.5	percent	of	the	EU’s	GDP.	This	compares	poorly	to	the	United	States’	$1.2	trillion	fiscal	intervention,	bringing	backmemories	of	a	delayed	response	(at	that	time	on	the	monetary	front)	to	the	global	financial	crisis.Unavoidably,	the	response	has	been	bolder	when	it	comes	to	ensuring	national	fiscal	flexibility;	the	activation	of	thegeneral	escape	clause	was	an	unprecedent	but	necessary	move,	as	national	governments	have	undertaken	majorfiscal	interventions,	which	according	to	Mário	Centeno,	are	on	average	3	per	cent	of	GDP,	and	liquidity	supportingmeasures	(e.g.	states	guarantees	for	loans	to	businesses	and	tax	deferrals)	that	reach	18	per	cent	of	GDP.The	European	Central	Bank	continues	its	activism,	bearing	once	again	the	main	burden	of	response.	Initially,	itadded	€120	billion	to	its	existing	Asset	Purchasing	Programme	(APP)	to	support	the	prices	of	assets	(includingsovereign	bonds).	At	the	same	time,	it	launched	a	new	emergency	refinancing	operation	to	provide	liquidity	to	thebanking	sector	and	expanded	the	volume	of	an	already	scheduled	refinancing	operation,	adding	€1	trillion	ofavailable	funds	at	extremely	low	(negative)	rates,	up	to	-0.75	per	cent.The	ECB’s	major	move	came	on	18	March	with	the	announcement	of	a	€750	billion	Pandemic	EmergencyPurchase	Programme	(PEPP)	with	increased	flexibility	in	terms	of	asset	class,	maturity	and	country	limits.	ThePEPP	has	had	a	strong	positive	effect	on	the	yields	of	southern	member	states;	a	further	decline	was	recorded	on25	March,	when	it	became	known	that	for	the	PEPP,	country	limits	on	purchases	will	be	relaxed	(Figure	1).The	EMU’s	fiscal	conundrumThe	projections	for	economic	growth	are	particularly	gloomy;	according	to	the	OECD,	the	direct	impact	of	thelockdown	measures	employed	range	for	most	Eurozone	member	states	from	20	to	30	per	cent	of	GDP	for	theperiod	of	implementation.	For	a	lockdown	of	three	months	this	translates	into	a	4-6	per	cent	loss	of	GDP	on	anannual	basis.	Taking	into	consideration	the	prospect	of	a	U-shaped	recovery,	which	is	increasingly	probable,	atleast	for	some	economies,	it	becomes	clear	that	the	size	of	funding	required	is	truly	unprecedented.Figure	3:	Change	in	yields	of	sovereign	bonds	(10-year	bonds,	selected	countries)Source:	Investing.comLSE European Politics and Policy (EUROPP) Blog: A rift that never healed: How old divisions are undermining the Eurozone’s future Page 3 of 5		Date originally posted: 2020-04-16Permalink: https://blogs.lse.ac.uk/europpblog/2020/04/16/a-rift-that-never-healed-how-old-divisions-are-undermining-the-eurozones-future/Blog homepage: https://blogs.lse.ac.uk/europpblog/The	conundrum	is	how	to	access	such	funds	without	triggering	another	debt	crisis.	Pilling	up	massive	new	loads	ofnational	debt	through	a	recession	is	likely	to	lead	to	serious	sustainability	problems	in	the	medium-term	forsovereigns	that	are	already	heavily	indebted,	particularly	when	yields	continue	to	be	elevated,	despite	the	ECB’sintervention	(Figure	3).The	PEPP	does	not	offer	a	remedy	in	this	respect;	states	continue	to	issue	debt	on	their	own	terms,	whichincreases	debt	by	one	euro	for	every	euro	raised.	Borrowing	from	the	European	Stability	Mechanism	(ESM)	alsoraises	debt,	and	the	same	is	true	for	other	proposals	which	operate	through	loans	to	member	states.The	only	way	out	would	be	to	raise	common	debt,	which	is	then	monetised	by	the	ECB	by	rolling	it	over	or	evencancelling	it.	Alas,	this	solution	would	be	against	EU	law,	and	a	non-starter	for	supporters	of	monetary	orthodoxy.The	alternative	would	be	a	no-debt	solution,	i.e.	direct	fiscal	transfers,	e.g.	from	the	EU	budget.	Fiscal	transfers	of	abig	enough	size	to	make	a	difference,	however,	is	exactly	what	northern	countries	are	trying	to	avoid.A	second-best	approach	would	be	to	raise	common	debt	with	a	very	long	maturity;	this	would	reduce	servicingcosts	for	indebted	countries	and	transfer	repayment	far	into	the	future.	Proposals	along	this	line	suggest	either	acommon	fiscal	mechanism,	or	a	common	debt	instrument.	Ideally,	their	set-up	would	differentiate	between	thereceiving	and	payment	keys;	in	other	words,	repayment	would	be	based	on	a	pre-determined	criterion	like	the	sizeof	the	economy	or	the	ESM’s	capital	key,	but	funds	would	be	distributed	according	to	the	severity	of	the	health	andconsequent	economic	crisis	(see	here	for	more	details).	Such	a	solution	would	increase	available	funding	forcountries	that	need	it	most,	without	increasing	their	debt	burden	at	the	same	rate.	This	would	result	in	a	limitedamount	of	fiscal	transfers	that	would	be	affordable	for	the	contributors;	provided	that	such	a	scheme	is	designed	asa	one-off	emergency	solution,	fears	of	a	transfer	union	should	not	come	into	play.Having	said	that,	progress	in	this	direction	seems	unlikely	given	the	mutualisation	of	risk	such	proposals	entail.	On26	March,	Germany	and	its	allies	rejected	the	request	of	nine	European	leaders	representing,	among	others,	thevulnerable	countries	of	the	south,	for	a	‘common	debt	instrument’.	The	decision	was	followed	by	a	spat	between	thePortuguese	prime	minister	and	the	Dutch	finance	minister.	The	divide	became	more	visible	than	ever	before.	Thedrama	climaxed	as	the	Eurogroup,	assigned	by	the	European	Council	to	come	up	with	new	proposals,	failed	to	doso	at	its	meeting	on	7	April.A	new	deal	is	on	the	table,	but	is	it	enough?A	compromise	was	finally	reached	at	the	Eurogroup	on	9	April.	It	is	based	on	a	multi-pronged	response	includingSURE,	the	European	Commission’s	Temporary	Support	to	mitigate	Unemployment	Risks	in	an	Emergencyprogramme,	which	will	fund	labour	market	measures	to	the	tune	of	€100	billion	through	debt	issued	by	the	EUbased	on	state	guarantees;	a	European	Investment	Bank	(EIB)	scheme	for	private	sector	loans,	also	based	onstate	guarantees;	and	new	credit	lines	from	the	ESM.Agreement	has	been	faster	compared	to	the	EMU’s	reaction	during	the	debt	crisis,	and	the	amounts	agreed	aresubstantial.	Having	said	that,	it	is	unlikely	that	the	package	will	be	enough.	The	ESM	funds	will	be	used	only	for‘direct	and	indirect	healthcare,	cure	and	prevention	related	costs	due	to	COVID	19’.	However,	healthcare	is	only	asmall	part	of	the	pandemic’s	economic	cost.It	is	uncertain	how	the	much	higher	cost	of	supporting	the	economy	during	lockdown	will	be	covered;	the	fuzzylanguage	employed	has	allowed	the	Dutch	finance	minister	to	state	that	support	for	the	economy	–	even	formeasures	directly	related	to	the	pandemic	–	would	come	under	conditionality,	at	the	same	time	that	the	Italianfinance	minister	was	asserting	that	‘conditionality	was	off	the	table’.Moreover,	the	critical	and	divisive	issue	of	how	to	fund	European	economies’	recovery	was	left	for	the	future;	onceagain	post-meeting	statements	from	the	Dutch	and	Italian	ministers	show	that	divisions	over	mutualisation	of	debtremain	unresolved;	a	repeat	of	‘kicking	the	can	down	the	road’	seems	increasingly	likely	when	it	comes	to	the	reallyimportant	decisions.LSE European Politics and Policy (EUROPP) Blog: A rift that never healed: How old divisions are undermining the Eurozone’s future Page 4 of 5		Date originally posted: 2020-04-16Permalink: https://blogs.lse.ac.uk/europpblog/2020/04/16/a-rift-that-never-healed-how-old-divisions-are-undermining-the-eurozones-future/Blog homepage: https://blogs.lse.ac.uk/europpblog/In	order	to	heal	from	the	impact	of	the	virus,	the	Eurozone	needs	to	heal	its	own	divisions.	Without	a	sizeablecommon	funding	mechanism,	the	danger	is	that	once	the	health	crisis	is	over,	European	economies	will	be	on	verydifferent	fiscal	and	macroeconomic	trajectories.	The	correction	of	these	imbalances	would	require	adjustmentpolicies	which	however	come	at	high	economic	and	political	cost;	what	is	more,	given	the	experience	of	the	debtcrisis,	they	are	unlikely	to	be	acceptable	to	the	countries	of	the	south.	A	new	clash	over	austerity	policies	woulddelay	the	economic	recovery,	weaken	further	the	EU’s	already	damaged	credibility	and	ultimately	risk	theEurozone’s	break-up.Please	read	our	comments	policy	before	commenting.Note:	This	article	gives	the	views	of	the	author,	not	the	position	of	EUROPP	–	European	Politics	and	Policy	or	theLondon	School	of	Economics.	Featured	image	credit:	European	Union_________________________________About	the	authorDimitris	Katsikas	–	National	and	Kapodistrian	University	of	AthensDimitris	Katsikas	is	Assistant	Professor	of	International	and	European	Political	Economy	at	theNational	and	Kapodistrian	University	of	Athens.	Between	2013-2020	he	was	Head	of	the	CrisisObservatory	at	the	Hellenic	Foundation	for	European	and	Foreign	Policy	(ELIAMEP);	he	now	heads	itsnew	Greek	and	European	Economy	Observatory.	His	most	recent	books	include	Public	Discoursesand	Attitudes	in	Greece	during	the	Crisis:	Framing	the	Role	of	the	European	Union,	Germany	andNational	Governments	and	Economic	Crisis	and	Structural	Reforms	in	Southern	Europe:	Policy	Lessons,	with	P.Manasse.LSE European Politics and Policy (EUROPP) Blog: A rift that never healed: How old divisions are undermining the Eurozone’s future Page 5 of 5		Date originally posted: 2020-04-16Permalink: https://blogs.lse.ac.uk/europpblog/2020/04/16/a-rift-that-never-healed-how-old-divisions-are-undermining-the-eurozones-future/Blog homepage: https://blogs.lse.ac.uk/europpblog/

A rift that never healed: how old divisions are undermining the Eurozone’s future

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A rift that never healed: how old divisions are undermining the Eurozone’s future

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